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Fiscal Cliff Meltdown Averted….for now

published: Jan. 02, 2013

Fiscal Cliff Meltdown Averted….for now

A last minute fiscal cliff deal/compromise was reached in Washington to avert the initial stages of a potential economic meltdown which was received warmly by the markets given the extent of the relief rally that we have experienced thus far on the first trading day of the New Year. However, we, at Hennion & Walsh, do not believe that we are anywhere close to signaling “all clear” on the Fiscal Cliff front and that the deal in question, while it averted some of the feared, short-term draconian tax increases associated with going over the cliff, did nothing to address the longer term, more encompassing budget issues as the compromise delayed any decisions on spending cuts for another two months. The compromise also did not deal with the impending Debt Ceiling debate, which promises to have both political parties digging in on their ideological heels.

Removing some uncertainty from the markets, what has been addressed in the deal/compromise were changes to the revenue side of the fiscal budget equation primarily dealing with tax rates and income levels associated with these tax rates. As we understand it at this point in time, based primarily upon a recent The Wall Street Journal article entitled, “Summary of Bill’s Tax Provisions”, here are some of the major provisions of the deal that were agreed to by the White House, Senate and House of Representatives – and one noteworthy tax that was not addressed in the deal.

The personal income tax rate for families with incomes above $450,000 (individuals with incomes above $400,000 and heads-of-households with incomes above $425,000) will increase. Any excess income above these levels will now be taxed at 39.6%. This represents the largest income tax rate increase in nearly two decades. The tax rates for families, individuals and heads-of households with income below these thresholds will not change and will remain at their existing Bush-era tax bracket levels.

The tax rate on capital gains and dividends will rise to 20% from 15% for incomes above the levels described in (1) above. These tax rates will remain at 15% for all other applicable taxpayers below these thresholds. Avoiding the tax treatment of dividend income at ordinary income rates, as opposed to the agreed upon tax rates of 15% or 20%, is viewed as a major positive for investors – especially those with dividend oriented investment strategies in their portfolios.

The estate tax will be increased from a top tax rate of 35% to 40% with a $5 million exemption level. This threshold will be indexed to inflation going forward.

The Alternative Minimum Tax (AMT) was patched to avoid raising taxes, through the AMT, on more middle-class Americans by raising the income exemption from $33,750 (individuals) and $45,000 (married couples filing jointly),as it would have reverted to for the tax year 2012, to $50,600 (individuals) and $78,750 (married couples filing jointly) respectively. The exemption amounts will be indexed going forward as well.

The deal did not address payroll taxes. As a result, the rate of payroll taxes for workers used to fund Social Security will increase from 4.2% (which was in place for the previous two tax years) to 6.2% as of January 1, 2013. According to The Tax Policy Center, approximately 77% of American households will face higher federal taxes in 2013 – not just income tax increases on wealthier American households but payroll tax increases on middle and low income American households as well.

While the details of the “first Fiscal Cliff deal”, addressing revenue (i.e. taxes), show that the compromises reached helped to lessen the initial taxable impact that would have been experienced by many taxpayers and investors if no deal had been reached at all, we remain concerned with the lack of any type of deal on spending cuts at this time. A “second Fiscal Cliff deal”, addressing spending cuts, would need to be reached within the next two months according to the outtakes of the first Fiscal Cliff deal. If an agreement between the two political parties on spending cuts cannot be reached in that timeframe, the Debt Ceiling debate would then return to the front burner as more debt would thus be needed (potentially involving another increase to the Debt Ceiling) to fund the existing Federal balance sheet imbalance.

Judging from past experience, we would anticipate that any agreement on a second Fiscal Cliff deal will probably come down to the wire, if not get postponed again, and that market volatility will likely continue to increase as we get closer to the new deadline.